12/04/2009 @ 5:30PM

The Dark Side Of TIPS

The U.S. government introduced inflation-indexed bonds in 1997. If purchased at the initial offering and held to maturity, an investment in these securities will return the inflation rate plus inflation-adjusted interest no matter what the rate of inflation is during the period.

Inflation-indexed bonds are often described as the ultimate risk-free investment. They are cited as a safe way to achieve your goal of paying for a child’s college education or your own retirement. Caveat emptor–let the buyer beware!

A typical advertisement for an inflation-indexed bond fund goes something like this:

“With Washington pumping huge amounts of stimulus money into the economy and the national deficit ballooning out of control, many investors are concerned that inflation–while probably not an immediate threat–lies somewhere over the horizon. Don’t let years of saving fall prey to the corrosive effects of inflation. Protect your wealth with the XWZ Treasury Inflation-Protected Securities fund.”

I would not argue with those who say that most long-term investors should have at least some of their retirement money in inflation-indexed bonds. However, there is another side to this story that is rarely discussed. There is a dark side to inflation indexed bonds.

First, some background. Inflation-indexed bonds come in two varieties, I Bonds and Treasury Inflation-Protected Securities (TIPS). While they do basically the same job, there are significant tax differences and the amount of I Bonds you can purchase each year is limited. Visit TreasuryDirect.gov for a detailed list of differences.

During the 1970s, inflation was climbing and interest rates followed. When interest rates go up, the values of existing bonds fall. That is a fundamental law of finance. By 1980, long-term U.S. Treasury bonds hit 15% interest and inflation peaked close to the same rate. Over the next three decades, inflation eased and interest rates gradually fell. Today, we have essentially zero inflation and about a 4% long-bond rate.

Bond investors would have been spared loses in the 1970s had there been inflation-indexed bonds. As inflation went up, inflation-indexed bonds would have become more valuable as their par values and interest rates adjusted upward. So what have investors leaned over the past 30 years? We have learned that when inflation goes up, interest rates go up, and the value of bonds go down–unless they are indexed to inflation.

So, where is the dark side?

Let me first say the financial markets have a way of doing things that we least expect. When everyone expects something to happen, it usually doesn’t. Today, a majority of people expect inflation to be a problem in the future because the Fed has increased the money supply significantly in an effort to stimulate the economy, and the thinking is this increase will ultimately lead to greater demand for goods and services, which will lead to higher inflation.

Let’s take a closer look at this traditional money supply inflation-cycle logic, because it may not apply this time around. We don’t have high demand for goods and services in this country due to high unemployment, and we likely won’t get back to peak employment for many years. Even when we do see unemployment decline, we have an aging population who has lost its appetite for increased discretionary spending financed by personal debt. Credit card debt is going down, and home equity is no longer a piggy bank to borrow from, now that one-fourth of Americans have mortgages larger than the values of their houses.

Add to this the Federal Reserve’s primary mandate to keep inflation low through monitory policy. Currently, monetary policy has placed interest rates near zero percent. The Fed cannot be any more accommodative unless they pay banks to borrow money.

The only place interest rates can go is up–and higher interest rates will likely squeeze any inflation out of the system rather quickly as loan demand will drop as soon as rates increase. Consequently, inflation is probably not the big threat that investors think.

So, what is the risk?

The risk is a loss of confidence by our trading partners who hold trillions of dollars in U.S. Treasury bonds. If our trading partners decide not to buy our newly issued bonds, or worse, decide to sell the bonds they currently hold, the supply of U.S. government debt washing around the global financial system will increase exponentially. Selling may beget selling as one country tries to dump ahead of others. The only way to make U.S. debt attractive again is for real interest rates to go up substantially to match the level of perceived risk in U.S. obligation. That is the big risk for TIPS investors.

The key point is this: Real interest rate increases are not the same as inflation-based interest rate increases. Bond yields are composed of two interest rates; the anticipated inflation rate and a real interest rate over inflation. These two rates can move in opposite directions. For example, assume a nominal 30-year Treasury bond has a 4% yield based on a 1% anticipated inflation rate and a 3% real yield. If foreign investors lose faith in the U.S. and start selling Treasury securities, and at the same time inflation falls to zero, the 30-year Treasury bond could rise to 5% with no inflation. A jump in the real interest rate presents a big problem for inflation indexed bond holders because neither their par value nor interest income will increase because there is no inflation adjustment.

A rise in real interest rates that coincides with low or disinflation (lower inflation) is an inflation-indexed bond holder’s bad dream. They would be stuck with low income from their TIPS, no increase in TIPS par value, and lower TIPS prices as bonds react to higher real rates. A nightmare scenario would occur if real rates increased from foreign selling and simultaneous deflation (negative inflation) in the U.S. This would cause TIPS prices to cascade downward due to deflation adjustments downward in par values and interest income and at the same time react to falling bond prices because real rates are rising.

I don’t know what the outcome will be for huge and growing deficits hanging over our country, and I don’t know if the increase in money supply will result in inflation down the road. But I do know that what people expect to happen typically doesn’t happen, at least not in the way they expect. I’m not bearish on inflation indexed bond products. However, I do recommend only a moderate allocation of perhaps 20% of your bond exposure just in case the unexpected becomes reality.

Richard A. Ferri, CFA is the founder and director of Research at Portfolio Solutions, LLC, a low-cost investment adviser firm in Troy, Mich. He has written numerous books on subjects ranging from asset allocation to index funds and ETFs.